EFP examples

A trader holds $150 million worth of bank bills maturing 70 days after settlement with a yield of 4.75%. He has arranged to trade these for ASX 90 day bank bill futures contracts with a price of 95.360.

If the trader wished to hedge the quantity of these bank bills he could trade them for the same ‘quantity’ of futures on a million-dollar-for-million-dollar basis. In this case he would look to trade these bank bills for 150 ASX 90 day bank bill futures contracts. Note that he could not do this if the physicals were a coupon-bearing bond.

Alternately, the trader could calculate the tick value of the physical to be approximately $2,800, and the tick value of a single ASX 90 day bank bill futures contract at that price to be $23.90. This would mean that (2800/23.9 =) 117 ASX 90 day bank bill futures contracts would hedge the exposure of the physical transaction. Due to the need for the size of the futures and physical to be of a “substantially similar” size, a small error margin either side of the ‘correct’ number of futures contracts will be permitted, but trades outside that margin will be rejected by the exchange as failing to meet the criteria for an EFP.

Finally, due to the difference between the maturity timeframe of this contract and the next-longer interest rate contract ASX 3 year treasury bond futures, it is possible to use multiple ASX 90 day bank bill futures contracts in order to hedge a longer physical exposure. If, for example, a broker was performing an EFP with a bond due to mature in 14 months and which had a tick size equivalent to 200 ASX 90 day bank bill futures contracts of a given price, he could exchange it for 40 contracts in the spot maturity (in two months time), 40 in the first forward expiry (five months away), and 40 each in the second to fourth forward expiries.

Before conducting an EFP using bond contracts it must be remembered that although exchanges based on quantity are permitted, the face value of a coupon-bearing bond is not able to be considered as its quantity. As a result it is usually expected that exchanges for these physicals will be based on tick value alone.

As physical bonds can mature at any time but futures contracts are based on projected returns for either three- or ten-year maturities, participants will be expected to hedge with whichever contract more closely follows the yield curve of the physical they are using. Note that strip EFPs can be used to combine three- and ten-year bond contracts into the same transaction.

Also note that most forms of bond are allowable as part of a bond EFP, including government, semi-government and corporate bonds, zero-coupon bonds, index bonds and even offshore bonds as long as there is a very high correlation with that of the Australian yield curves, such as might exist in the issuance of New Zealand or Canadian government or semi-government bonds.

If we take the most basic form of the transaction, however, a participant might wish to hedge the trade of a $40 million CGL bond with five years to maturity, a 10% coupon and a 5.6% yield with ASX 3 year bond futures contracts priced at 94.900.

If this were the case, the tick value of the physical would be calculated to approximately $19,180 and the tick value of the future to $27.91/contract. As such, ($19,180/$27.91 =) 687 contracts would be required to hedge the exposure taken on in the transaction and this number of futures would be expected to be exchanged in the transaction.

If a modified-duration hedge was desired, the trader could hedge this exposure using a ‘strip’ EFP combining ASX 3 year bond futures and ASX 10 year bond futures contracts. The first step here is to determine the proportion of these contracts that would be required, and this requires working out the modified duration of each component. Once this has been done the futures must be combined in such a way that the modified duration of the futures strip equals that of the physical.

Note that an exposure of a bond whose term is shorter than three years would be able to be hedged in a similar manner through the use of ASX 3 year treasury bond futures and ASX 90 day bank bill futures. Note, too, that this principle can work the other way – a series of bonds may be hedged against one (or more) futures positions – or that a physical can be hedged against a future and another physical.

An EFP using bond futures can be used to hedge a transaction in offshore bonds. If the bond is determined in Australian dollars (a kangaroo bond) the hedge is determined as normal. If not, allowance should be made for the exchange rate. Note that only foreign bonds that have a yield curve highly correlated to the Australian yield curve will be accepted.

If, for example, a trader wished to hedge a New Zealand bond transaction with ASX 10 year treasury bond futures contracts where the bond expired 10.5 years from settlement, had a coupon of 6.0%, a yield of 6.37% and NZ$ 80 million face value. ASX 10 Year Treasury Bond Futures contracts are available at a price of 94.200.

In this case the NZD tick value is first calculated to be NZD 59,494. From this we then take the AUD tick value by multiplying by the exchange rate. If NZD 1 = AUD 0.809, this tick value is equivalent to AUD 48,131, and therefore approximately 635 XT contracts would be the required hedge.

It is also possible to hedge over-the-counter bond options against futures in an EFP transaction. These are worked out as normal – the tick value of the option is determined and compared to the tick value of the futures.

Swap contracts can also be hedged with ASX 3 year treasury bond futures and ASX 10 year treasury bond futures contracts. The tick value of swaps, which have a floating rate and a fixed rate component, can be calculated in a similar way to bonds. The fixed rate side of a swap is similar to a coupon-bearing bond.

A five-year swap with a face value of $100 million and a fixed rate of 7% can be calculated as having a tick value of approximately $41,500. This equates the fixed-rate side of the swap with a five-year, $100 million, semi-annual bond having a 7% coupon and a 7% yield. The tick value of a ASX 3 Year Treasury Bond Futures contract at 94.900 is $27.91/contract. Therefore, the number of these ASX 3 year treasury bond futures that are required to hedge this swap is approximately 1,489 lots. It would also be possible to use a combination of ASX 3 year bond futures and ASX 10 year treasury bond futures to hedge this swap.

ASX SPI 200 futures may be traded against a basket of one or more ASX-traded stocks, at a rate that either does or does not account for the volatility of the basket.

If a trader held 100 ASX SPI 200 index futures contracts and wished to trade them against a basket of stocks at a price of 3425 he would be able to trade them against any basket of ASX-traded stocks with a total value close to (100 x 3425 x $25) = $8,562,500.

Alternately, if he wished to be able to hedge the volatility of the basket he could trade for ($8,562,500/0.9) = $9,513,889 worth of shares with a portfolio beta of 0.9 or ($8,562,500/1.1) = $7,784,091 in shares with a portfolio beta of 1.1.

It is possible to trade a strip ASX SPI 200 index futures EFP to achieve a desired partial-tick price. If a trader desired they could trade 70 AP contracts at 3421 and 30 at 3420 to achieve the same result as trading 100 contracts at a price of 3420.7.